Question

​(Divisional costs of capital and investment decisions​)

Saddle River Operating Company​ (SROC) is a​ Dallas-based independent oil and gas firm. In the​ past, the​ firm's managers have used a single​ firm-wide cost of capital of 14 percent to evaluate new investments.​ However, the firm has long recognized that its exploration and production division is significantly more risky than the pipeline and transportation division. In​ fact, firms comparable to​ SROC's E&P division have equity betas of about 1.5​, whereas distribution companies typically have equity betas of only 0.9. Given the importance of getting the cost of capital estimate as close to correct as​ possible, the​ firm's chief financial officer has asked you to prepare cost of capital estimates for each of the two divisions. The requisite information needed to accomplish your task is presented​ here:

• The cost of debt financing is 7 percent before taxes of 34 percent.​ However, if the​ E&P division were to borrow based on its projects​ alone, the cost of debt would probably be 8.6 ​percent, and the pipeline division could borrow at 6.2 percent. You may assume these costs of debt are after any flotation costs the firm might incur.

• The​ risk-free rate of interest on​ long-term U.S. Treasury bonds is currently 6.3 ​percent, and the​ market-risk premium has averaged 5.6 percent over the past several years.

• The​ E&P division adheres to a target debt ratio of 40 ​percent, whereas the pipeline division utilizes 50 percent borrowed funds.

• The firm has sufficient internally generated funds such that no new stock will have to be sold to raise equity financing.

a. Estimate the divisional costs of capital for the​ E&P and pipeline divisions.

b. What are the implications of using a​ company-wide cost of capital to evaluate new investment proposals in light of the differences in the costs of capital you estimated​ previously?

NEED ANSWER TO THESE QUESTIONS:

a. What is the divisional cost of capital for the​ E&P division? ____​% ​(Round to two decimal​ places.)

What is the divisional cost of capital for the pipeline​ division? ____​% ​(Round to two decimal​ places.)

b. ​"The dramatic difference in the two divisional costs of capital underscores the importance of analyzing the capital costs corresponding to divisions of very different​ risk."   

Is the above statement true or​ false? ▼ True. False.   ​(Select from the​ drop-down menu.)

Answer 1

SEE THE IMAGE. ANY DOUBTS, FEEL FREE TO ASK. THUMBS UP PLEASE